United States v. Cain

Appeal from the United States District Court for the Southern District of Illinois. No 81-4501 -- Kenneth J. Meyers, Magistrate.

Eschbach and Posner, Circuit Judges, and Marshall, District Judge.*fn*

Author: Marshall

MARSHALL, District Judge.

Appellee, the United States, brought this action to enforce personal guaranties on a loan in which the Small Business Administration (SBA) participated. Appellants, the guarantors of the loan, raised the affirmative defense that the SBA had breached its duty of good faith which appellants claimed was owed to them. By consent of the parties, the case was referred to a United States Magistrate pursuant to 28 U.S.C. § 636(c) (1982) to conduct all proceedings in the matter. Both parties moved for summary judgment. Rejecting appellants' good faith defense, the magistrate entered summary judgment in favor of the United States and against appellants. Whether the SBA owed appellants a duty of good faith and, if so, whether the SBA breached that duty are the issues now before this court on appeal.

At the time of the loan in question, appellants, Gerald, Evelyn, Collin and Janice Cain, owned stock in Custom Poly Bags, Inc., an Illinois corporation with its principal place of business in Union County, Illinois. On April 17, 1974 Anna National Bank (Anna) loaned Custom Poly Bags $175,000. Custom Poly Bags pledged its assets as security for the loan. Appellants executed personal guaranties of the loan.*fn1 In exchange for the SBA's guaranty of the loan, Anna assigned to the SBA the note and the right related to the note, including appellants' guaranties and the collateral.

Later, Custom Poly Bags needed more money to continue its operations. Anna loaned it an additional $60,000. So that Custom Poly Bags could provide the security Anna demanded for the additional loan, the SBA subordinated its rights in the original collateral to Anna. The SBA did not notify appellants of the subordination.

On July 1, 1978 Custom Poly Bags sold its assets to CDI, Inc. CDI assumed Custom Poly Bags' obligations under the two loans. Both Anna and the SBA approved the sale.

In late 1980 or early 1981, Munn's Medical Supply purchased the $60,000 note from Anna. Upon default by CDI, Munn's foreclosed on the collateral and held a public sale pursuant to Ill. Rev. Stat. ch. 26, § 9-504 (1983). Munn's was the sole bidder and purchased the collateral for $60,000. Although Munn's informed the SBA of the public sale, no SBA representative attended, nor did the SBA notify appellants of the sale.

The original note for $175,000 was also in default. SBA made good on its guaranty to Anna and the United States then brought this suit against the appellant guarantors on their guaranties.

In subordinating its interest in the collateral, the SBA acted within its rights under appellants' contract of guaranty which expressly empowered the SBA, in its "uncontrolled discretion," to consent to a total release of the security without notice to appellants. The guaranty imposed no requirement on the SBA to receive collateral of the same value or nature in return for the release. Thus, the SBA could, under the contract, release the collateral for no consideration. Clearly, the SBA's subordination of its rights to the collateral, even without notice to appellants and without collateral in exchange, was not a breach of the guaranty contract. The magistrate premised his decision to grant the United States summary judgment on the terms of the guaranty.

Appellants argue that the SBA's duty to them exceeded that provided in the contract. They assert that the SBA owed them a duty of good faith, which required the SBA to act in a commercially reasonable manner and that the SBA breached that duty by failing to notify them of the subordination, to receive an adequate exchange for the subordination, and to supervise the maintenance and sale of the collateral after the subordination.

The source of the duty of good faith, appellants suggest, is § 1-203 of the Uniform Commercial Code, enacted in Illinois as Ill. Rev. Stat. ch. 26, § 1-203 (1981). Although both parties agree that federal law governs this case, appellants argue that state law, and therefore, the Uniform Commercial Code, should provide the rule of decision. This circuit has applied the U.C.C. in determining the rights and obligations of guarantors with respect to the SBA. United States v. Warwick, 695 F.2d 1063 (7th Cir. 1982). There the court upheld a district court determination that a sale of collateral after default was commercially reasonable.*fn2 Hence, we will look to state law, and therefore, the U.C.C. to determine the standard of care owed by the SBA.

Section 1-203 of the U.C.C. provides, "Every contract or duty with this act imposes an obligation of good faith in its performance or enforcement." Ill. Rev. Stat. ch. 26, § 1-203 (1981). The U.C.C. defines "good faith" as "honesty in fact in the conduct or transaction concerned." Id. § 1-201(19). Appellants contend that the duty of good faith includes the requirement of commercial reasonableness. The U.C.C. definition of good faith, however, is distinct from commercial reasonableness except in the context of merchants.Article 2 of the U.C.C. which applies to sales of goods imposes upon merchants a higher standard of good faith, requiring not only honesty in fact, but "observance of reasonable commercial standards" as well. Id. § 2-103(b). In the present context, we do not deal with transactions in goods nor is the SBA a merchant; hence § 2-103(b) does not apply.

The cases to which appellants direct our attention, requiring the SBA to act in a commercially reasonable manner, all involve the sale of security after default. Under Article 9 of ...

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